Pay for Performance
Organisations wants workers to work hard and put in effort. How will they achieve this? Encouraging Optimal (First-Best) Behaviour - TLDR: incentives * The organisation has to induce workers to make decisions that will benefit the organisation * Making decisions, solving outcomes, how much to put in effort, what projects to pursue all incur personal benefits and costs to the worker. * Benefits and costs of workers are benefits and costs to the organisation. * Optimal behaviour maximises value. Organisations should try to achieve this by maximising worker benefits and minimising worker costs. * This is maximising total surplus w - c * Incentives such as bonuses can be used to induce first-best behaviour if profit is perfectly observable * General Contracting Principle - Pay to Play ** Residual Claimant, worker receives all the remaining renumeration after products/service being paid. ** Set piece rate to profit margin and lower the wage. ** Possible if not risk averse, not financially constrained, there is good performance measure and knows what actions maximises surplus. ** May even make the worker pay to work. Cost of providing incentives * Measuring performance ** How do you measure performance of workers correctly and accurately? ** If performance measures are poor indicators of a worker's behaviour it is hard to apply pay for performance. ** Firm may be unaware about what to pay to increase performance and not know what to measure. ** eg: a1 = customer service, a2 = customer support ** Pi = effort a1 + effort a2 + e(random noise) ** P(a1, a2) = effort a1 + effort a2*g(responsiveness of effort). Firm does not see the individual effort but a sum instead. ** Firm gets Pi - wage - bonus*measurementP = Pi - w - bP ** Worker gets wage + bonus*measurementP - C(a1, a2) = w + bP - C(a1,a2) ** C(a1, a2) is personal cost function with a1 and a2 are the type of effort the workers put in ** MAXIMISE w + bP(a1, a2) - C(a1,a2) *** find a1 and a2 in terms of bonus, b ** Worker will PARTICIPATE if w + bP(a1, a2) - C(a1,a2) >= u ** Therefore minimum to make worker participate is w = u + bP(a1, a2) + C(a1,a2) ** differentiate d(a1+a2) by bonus, b to find marginal benefit of higher bonus ** differentiate C(a1, a2) by bonus, b to find marginal cost of higher bonus *** Optimal bonus = marginal benefit of higher bonus/marginal cost of higher bonus ** Profit depends on how well the bonus is aligned with the profits, not how responsive the profit is to the bonus ** Multitasking can be a problem. Raise the cost of doing other activities while increasing bonus of preferred activity. *** P = a1 + e *** Pi = a1 + a2 + e *** Worker willing to put in a1 + a2 = 2A and a1 = A effort *** Interdependent tasks C(a1,a2) = 1/2*(a1-A)^2 + y/2*(a1+a2-A)^2 *** if y>0 task 1 and 2 and substitutes with more effort in a1 raising marginal cost of a2 *** if y<0 task 1 and 2 are compliments with more effort in a1 reducing marginal cost of a2 *** In absence of performance pay, workers will put equal effort into both a1 and a2. *** Worker will choose to allocate effort more optimally when bonus bP is paid. Profits will increase with more effort in one task then another. *** When tasks are substitutes, rewarding one task reduces incentive to do another. *** When task 1 becomes more profitable, workers will do less of the task 2 and attempt to reduce the cost of profitable task by lowering effort on task 2 *** When faced with multiple tasks, workers will only perform the tasks that are rewarded *** If task 2 gives profit than the other but can only pay for task 1, don't do performance pay at all. * How to get around poor performance measure ** balance incentives ** better job design ** set firm boundaries ** reduce incentives and monitor better * Financial constraints ** How much to do you pay the workers to get them to put in effort? ** If workers do not like variability in pay and are financially constrained(can't pay to work) then incentives are hard to implement. ** If the workers can't pay the firm to work firm can't capture the total value charging the worker ** When there are no financial constraints, the performance measure P = Profit, Pi ** Increasing bonus in this case will lower profits ** Solution *** Hire less constrained workers *** Set piece rate below gross profit margin *** Facilitating Finance * Compensation risk ** Most workers are risk averse ~> care about expected pay and fluctuations in pay ** Most firms are risk neutral ** Increase in piece rate makes the risk averse worker's risk costs larger ** This makes it costly to provide incentives ** Solution *** Set piece rate below gross profit margin *** Set higher price, the more product the worker is, the less risk averse the worker is and the less noisy the performance measure is *** Hire less risk averse workers *** Reduce noise(reduce complication?) in performance measure * Adaptation costs ** What if the workers start demanding more and more benefits? ** Firm doesn't know what to do but worker knows more about what to do to benefit the organisation. ** How do you get the worker to act on this? Hidden Dangers of Performance Pay * Faking performance improvements * Sabotage other workrs * Reducing performance now so as to increase performance later for better pay, the Ratchet effect ** Solution: Solving commitment issues. Put in piece rates so that workers can get commissions straight from the beginning. Don't let them hold back Indirect effect of Performance Pay: Selection * Filters out unmotivated and lazy workers. * More motivated and talented workers stay and apply while the rest leave or do not apply Question solving * Compare wage+bonus-personal cost to wage * Expected utitlity is the maximum between bonus-cost or zero + wage * To find minimum bonus willing to work for divide personal cost by effort measurement(P) *